- A change of direction
- A chorus of the disappointed
- The shareholder value revolution
- Better ways of reporting?
- Shareholder power
- An unholy alliance
- Alliances need arbitrators
- Pragmatism is necessary
- Something has gone wrong - shareholder value has gone too far
- The lucky leaders are setting the example
- A slow but steady shift
A change of direction
Public companies exist to make money. All capitalist systems rely on this premise, and Western economies could not function without it. That’s not to say they are perfect, but discourse in recent decades has focussed on the degrees of freedom appropriate for - enterprise, the level of government interference, and the extent of state-led redistribution.
In the next 10 years, this debate about capitalist systems will change direction. No longer a conversation about the structure of modern economies, the focus will shift to the role of the system’s central agents: companies.
A century of unsustainable development fuelled by the mantra that companies’ sole purpose is to make profit, as famously advocated by Milton Friedman in 1970, is starting to give way to the view that the rent they extract from society does not come free, but obliges them to contribute under their ‘social contract’. This “new worldview” is breaking Friedman’s 50-year old Anglo-Saxon consensus, offering a new model for capitalism.
The seeds of change have been laid. The bipolar world of the cold war defined by communism and capitalism no longer exists. The collapse of the Soviet Union led eventually to an oligopolistic economy with autocratic features, a trend now echoed in more recent developments in Turkey or Brazil. New poles are emerging, most significantly in China, where hybrid models are evolving, requiring a more nuanced lens. In the West, too, there are changes as fewer believe in the American dream, or ever-closer integration in Europe, or globalisation as the solution to poverty. The old order is gone.
A chorus of the disappointed
Diverse as all these places are, there is one common theme: the disenfranchised citizen. One who longs for a world where fairness and justice seem closer, choices are simpler, and outcomes more aligned with effort. Around the globe, in places as far afield as the Philippines, Russia, Brazil, Poland, the UK, France, Italy, Austria, Hungary, and the US, these voters are turning to politicians who promise a return to former glory or a restitution of the working classes, anchored in nationalist agendas.
Populism is a reaction against the post-war order and the more recent liberalist ‘Washington consensus’ with its notions of free trade, open borders and globalisation, compounded by refugee crises. In 10 years’ time, this rejection may have passed - a temporary movement that galvanised populations but couldn’t achieve anything. But history may well point the other way if growth slows and conflict continues while global temperatures and sea levels keep rising, and a new generation more preoccupied with fairness and justice comes of age. A crescendo of populist dissent would only lead to more instability and volatility over the coming decade.
At its core, populism is a quest for more equal sharing in economic progress among people who feel the current system is not working for them. And because companies are the engine of all capitalist systems, the focus is turning to the role they have in society, how much they contribute to its cohesion, and who benefits.
Higher wages would go some way to address the populist agenda, reversing the growing share of excess value that has flown into shareholders’ pockets at the expense of customers and employees. They could have profound effects: for most companies, wages are a major part of the cost structure. A higher return to workers, in the form of rising wages, depresses corporate profit margins, putting pressure on shares which are priced on multiple of earnings, and bonds, which are vulnerable to cash flows.
The shareholder value revolution
Maybe the concept of shareholder value itself is flawed.
The objective of maximising shareholder value has long been criticised for being too narrowly focussed, with insufficient consideration for environmental impacts, employee welfare or community health. What is new is how widely this discussion is now being conducted, and the momentum it is gathering.
Shareholder value assessments rely on financial reporting and this is the focus of much of the debate: standard financial reports on their own are too narrow and cannot account for other roles the company assumes in society as it interacts with other stakeholders. Reporting remains critical, but is not sufficient to determine the value that a company adds or detracts in other areas. It is now abundantly clear that, for example, natural resources are in many cases being used faster than they can be regenerated – not that this would be reflected in any company’s financials. Likewise, intangible assets dominate the balance sheet for many modern companies, which adds to the need for reporting changes.
Academic literature includes a plethora of studies on the longer-term financial benefits of more sustainable corporate behaviour, and the obligation of companies to redefine their place in the world.
Even Adam Smith himself, the father of modern economics who is often invoked in defence of corporate behaviour, may well have objected to the singular pursuit of profitability, or qualified its aim.
Smith explained how the invisible hand of the market translates the pursuit of self-interest into a public benefit. He did not equate self-interest with selfishness or greed, so well satirised in Gordon Gekko’s famous speech. Smith’s concern was with artisans and small farmers trying to make a living through trade. His world was one of often monarchist governments “instituted for the defence of the rich against the poor” and businessmen out to “deceive and even oppress the public”, whose rent-seeking taxes, subsidies and monopolies curtailed the competition that makes a market economy effective.
Once the champion of shareholder value, business schools are also examining corporate purpose. In 2018, INSEAD, one of the world’s leading graduate business schools based in Paris, launched “A force for good” campaign, aiming to raise €250 million by 2023 to be used to “advance business as a force for good in the world”, with a new institute focusing on “how organisations can better align with the goals of society and work in service of the greater good”.
In the UK, Colin Mayer, professor of management studies at Saïd Business School at the University of Oxford, argues that companies should not always seek to maximise share prices, because the purpose of business is not to maximise profits. Profits, Mayer says, are a product, not a purpose, of business; the purpose of a business is to make goods and services which benefit us as customers and communities. It is in the process of making goods that companies do good, and make money, he explains, concluding that company owners and their boards should therefore be starting from specifying what the business should be doing.
John Kay, another leading UK economics professor, has been making similar arguments for decades, stressing that a company is a social and not just a financial organisation, and by necessity a cooperative venture. Its social legitimacy must be earned and cannot just be asserted. It also is not to be confused with much narrower CSR (corporate social responsibility) or ESG (environment, social, governance) mission statements. In recent years, however, there have seen too many examples of broken social contracts. Increases in executive remuneration that lack justification, aggressive tax avoidance schemes and corporate greed have all driven a wedge between management and accountability, leading many to doubt the merits of capitalism. Regaining trust is therefore in the interest of the business community; the alternative undermines the success of the market economy.
In the US, Malcolm Salter, professor of business administration at Harvard Business School, argues that the ‘canonisation’ of shareholder value maximisation as the only legitimate expression of corporate purpose is a leading cause of the fault line between capitalism and justice, and the public’s alienation from the system.
Salter suggests a wider perspective that stresses the ethicality of cooperation in transactional settings, and the efficiencies and adaptive benefits flowing from cooperation. Such a redefined purpose, based on established principles of justice and organisational efficiency, recognises the utility in reciprocal, cooperative relationships, which is not a priority in a shareholder value maximisation regime. His work includes an analysis of how such behaviour could take hold in an environment still dominated by shareholder value maximisation, pointing to the key role for business schools training the next generation of leaders, and institutional investors who together own a majority of corporate equity in the broad-market US Russell 3000 index and the S&P Euro index.
Better ways of reporting?
The real world is taking notice. New ideas about corporate purpose, shareholder value and reporting are rapidly moving into the mainstream debate, well beyond academia. As a result, corporate behaviour is starting to change as companies recognise trends that will strengthen the pressure on them to report and act more sustainably, with a bigger focus on human, social and environmental capital. This will be one of the defining characteristics of the next decade.
One example of this is Mervyn King’s proposal for integrated reporting, as highlighted in the Financial Times. King, a South African supreme court judge now in his 80s (and a namesake of the former Bank of England governor), has served on numerous boards of listed companies, chaired task forces on insider trading, and advised the South African finance ministry, the UN and the World Bank.
In consultation with hundreds of companies and financial professionals, King has developed a framework of corporate reporting that takes all sources of capital into account - financial, manufactured, intellectual, human, social and natural. Still largely aspirational, it is, however, now mandatory in a few countries including South Africa and Brazil, and supported by regulators in China and India. In 2017, an EU directive urged 6000 large listed companies to adopt it. Worldwide, about 1600 companies are adopting integrated reporting, including Tata, Unilever, Nestlé and Novo Nordisk, a trailblazer which made it part of its ‘triple bottom line’ balancing act of financial, social and environmental considerations as early as 2004.
In March 2018, the International Federation of Accountants published research showing that higher integrated reporting quality is associated with greater firm value, greater liquidity, and higher expected future cash flows, and that there is no evidence it raises the cost of capital. High-quality integrated reporting was positively associated with firms’ investment efficiency, and importantly, the benefits were incremental to those associated with existing reports, such as standalone corporate social responsibility reports.
King’s proposals build on earlier initiatives like the Global Reporting Initiative, which set best-practice standards for companies’ sustainability reports, helping them understand their environmental, social and economic impact including human rights and corruption. However, such sustainability reports are additional to financial ones rather than integrated, and are sometimes said to be qualitative rather than quantitative, or favour quantity over quality of reporting, at times turning into PR exercises.
It doesn’t help that there are some 230 different corporate sustainability standards of which the GRI is only one. But there is now a push to streamline them, which will renew the impetus for comprehensive reporting in the next decade. That is not surprising; large investors – including Norway’s oil fund, for example - are increasingly looking for those hidden long-term risks with a view to reducing their exposure.
Asset owners have been pushing boards for a while to pay more attention to worker protection or environmental issues. Some have done so publicly through collective engagement or voting at shareholder meetings. In 2018 BlackRock CEO Larry Fink issued a letter to CEOs on how companies must have a social purpose and pursue a strategy for achieving long-term growth. Critics say Blackrock’s voting record is not aligned with the intentions of Fink’s letter and are pushing it to take a tougher line with companies it invests in, but the letter proved a seminal moment in the public’s awareness of the issue. Many other asset managers raise concerns behind closed doors, nudging companies to change using both carrot and stick.
Not even the largest companies are immune to this. Shell is the first major oil company to yield to investor pressure and activists’ campaigning in a “stunning” U-turn, but it won’t be the last. Having earlier claimed that setting hard targets was a “superfluous exercise”, Ben van Beurden, its CEO, promised in December 2018 to set specific emission targets from 2020, link these to executive pay, and review Shell’s role in industry lobbying that could undermine the Paris accord targets.
In May 2018 van Beurden had managed to convince shareholders to vote against a shareholder resolution calling for a radical shift away from fossil fuels, submitted for the third time running by Follow This, a 4000-member strong green shareholder activist group founded by ex-journalist Mark van Baal which accumulates shares in oil companies to press them over emissions. The group has already filed another resolution against Shell for 2019, and its first one against BP. Chevron and Exxon Mobil may be next.
Van Baal calls institutional investors the “real heroes” in Shell’s story. Robeco and the Church of England have been leading investors pushing the company for more change, but they are backed by Climate Action 100+, a group which includes large firms like UBS Asset Management and has more than $32 trillion in assets under management. Investors’ aims are larger than just Shell, and their horizons longer than just one year. This is clear from the open letter to the FT signed by 60 large investors from around the world, including Fidelity International, urging the oil and gas industry to be “more transparent and take responsibility for all of its emissions”. It was a message from investors that they are embracing their responsibility for supporting the Paris agreement and expect the industry to do the same.
Public sector pension funds, which together manage trillions of dollars are also throwing their weight behind social and environmental causes, at times even threatening to withdraw funds. They are increasingly concerned about the longer-term risks to returns if companies do not pay heed to their social or environmental role, which could interfere with their fiduciary duty to act in their members’ best interest. No longer marginalised at shareholder meetings, their voices are taken more seriously in a reflection of mainstream debate. Bain Capital and KKR, the private equity firms, agreed to fund a severance agreement for workers of the bankrupt US company Toys R Us in 2018, following loud protests from workers’ advocacy groups. And in 2017, Blackstone agreed to a ‘Responsible Contractor Policy’ in response to pressure from organisations with hundreds of billions of pension assets.
An unholy alliance
However, talk is cheap. It is easy for companies to say all the right things but putting it into action less so. Companies aim to make money and their executives’ remuneration is based on share prices, so they need to be nudged along. Any meaningful change will require changing management pay and share buy-back practices, and empowering all other relevant stakeholders.
Some of this nudging will come from external developments that will intensify over the next decade. Evidence of climate change, for example, is forcing companies to document their environmental impact and rethink their longer-term strategies. Populism is manifesting itself in widespread displeasure at CEO salaries and the exploitation of low-paid workers on flexible contracts. In our digital ‘gig’ economy, which will face much more structural disruption in coming years, these concerns won’t go away. Corporate reputations will become more vulnerable, which will force shareholders to take them into account.
But the world is complex, and to think companies will easily become agents of change is naïve. For any change to be meaningful, all interested constituencies must cooperate. And there’s the catch: there is an uneasy alliance between companies’ three key stakeholders - shareholders, employees and customers (or local communities). Their agendas differ significantly, making it difficult for them to cooperate and agree on priorities. This will slow the evolution of the concept of shareholder value, but not halt the emerging trend towards a broader definition of it.
Alliances need arbitrators
Without mediation or enforcement, the alliance between the three interested constituencies is inherently unstable, and exploitation is a real risk. For companies to heed the interests of all three parties, someone must watch over their actions. This is the missing piece.
A company’s board, its external auditors, and the government need to be arbitrators of this alliance together. Where corporate behaviour has not met what we would now call ESG standards, it’s so often because they have not acted in this capacity. Corporate history is littered with examples: Enron’s balance sheet trickery under the eyes of its auditors, excessive risk taking at Bear Stearns, Starbucks’ accounting manoeuvring to avoid paying tax, or BP’s misguided savings that resulted in the Deepwater Horizon oil spill, attributed by a White House commission in 2011 to cost-cutting decisions and an inadequate safety system.
Pragmatism is necessary
There is no hard-and-fast rule that makes the three constituencies work together successfully, or that prescribes how they should be supervised. It takes a combination of grass-roots engagement, employee empowerment, shareholder commitment, and supervisory focus, for businesses to change their behaviour sustainably.
Governments need to ensure that no entity is exploited. Anti-trust legislation, for instance, needs to protect consumers from exploitation in a continuous effort. Where governments turn a blind eye, excesses often occur, and markets with few players or significant M&A are particularly exposed. Even where regulatory offices are vigilant, exploitation can still occur. The UK’s Competition and Markets Authority, for example, has launched a major investigation into funeral services, voicing concern about substantial and above-inflation price increases, not matched by the rise in costs or improvement in services, and noting that online price transparency is lacking and that the clients - people in mourning - are much less likely to shop around.
It is also telling that populist movements have led to local authorities acting where the national government refused to do so, as with the various environmental protection initiatives launched by individual US states.
Proper oversight is not complete without independent auditors. However, critics may point to instances where the relationship between large companies and their auditors has been too cosy. The latest troubles at Nissan are a classic example of auditors not paying enough attention. It is not the first instance of auditors growing too close to their clients, and won’t be the last. It has proven difficult to ensure true independence under the current business model that sees auditors paid by those they are meant to keep in line. This will act as a drag on the change populists are demanding.
But government and auditor action alone is not nearly enough: companies’ boards will need to play a much more active role in steering corporate behaviour. It is their responsibility to ensure the views of customers, employees, local communities and other relevant parties who might otherwise not have a voice are considered, for example through surveys. So far, there is limited evidence that this is happening, partly because of a lack of diversity that is reflected in close relationships between boards and executive teams.
Boards will need to show a better understanding of how expectations of business are evolving, and a clear sense of social purpose and integrity in the companies they lead. The laggards among them will face increasing negative publicity, customer displeasure, and environmental liabilities - all sources of brand erosion. The pressure on boards to provide a broader steer may turn out to be one of the biggest changes in the next decade.
Something has gone wrong - shareholder value has gone too far
Populism manifests itself in different ways. It can exert pressure through product pricing (customers voting with their feet). It can lead to political pressure, for example to tackle exploitative labour practices like flexible contracts that offer little protection to workers. Or it can focus on executive pay and lead to widespread negative coverage for both the largest earners in a company and the brand itself. In all these areas, pressure has been building, and it may only be a question of time before boards up their game.
The extraordinary gap between chief executive and average employee pay is widely considered the key reason boards needs to make a stand in ensuring a fair balance. But just as importantly, share buybacks in the US have escalated to an extraordinary degree, with a projected record amount of $1 trillion in 2018.
Corporate profits could instead be reinvested, returned to shareholders in the form of dividend, or returned to other stakeholders in the form of lower prices (which is very unlikely) or pay rises (which is a little more likely).
Corporate managements are rewarded on total shareholder value; so for them, buying back shares makes perfect sense. Companies themselves often justify buybacks in terms of discipline and confidence. But almost a decade into a stock market boom, executives are buying shares when long-term valuations have rarely been higher. And in some cases, companies have loaded up on cheap debt to fund those buybacks.
Most damning is the comparison with dividend payments. Only once in the last 15 years did dividends exceed buybacks - and that was in 2009, when stocks were the cheapest in a generation and buybacks would have made much more sense than they do now. Dividend increases and buybacks both count as ‘shareholder-friendly’ actions, but they are very different. Share buybacks can send mixed messages, but rising dividends are a sign of corporate strength.
Companies are unlikely to change their ways while current incentive schemes stay in place. Nor can shareholders be expected to raise complaints about corporate behaviour that fills their own pockets.
The pressure will need to come from boards, who, supported by external auditors, should examine the alternatives to deploying capital. With populist voices gaining strength they will be under increased scrutiny to do so, even if progress will be slow.
In the US, this would involve the SEC revisiting the legal ‘safe harbour’ for buybacks, which was introduced in 1982 to stop accusations of manipulation. Management should be required to show that buying back shares exceeds the cost of capital, or in other words, that it is a better investment than anything else. Billionaire investor Warren Buffett, for example, has said he will only buy back stock when shares are at less than 1.2 times the stated book value of assets.
The lucky leaders are setting the example
Companies that try to balance the demands of all three constituencies are most likely to win out in the end. The lucky ones are the ‘miracles of capitalism’ that have such a strong market position - Unilever, JP Morgan Chase - than they can earn above-normal profits and still be perceived positively by employees and customers.
The pressure for them to change will not let up. Wages for lower-income groups have failed to keep up with inflation in many countries and any future economic slowdown will hit the poorest income groups hard. The wealth gap between the top and the bottom earners is high or rising still. Wealth effects are compounded by retirement savings shortfalls, which hit lower income groups with fewer assets hard, and low returns mean employees need to set aside much more just to maintain expected pension levels.
The damage to our environment is expected to force many more to leave their homelands and raise inequality worldwide, feeding populist sentiment. Even under optimistic forecasts that assume “drastic” greenhouse gas emission reductions, half of the world’s population will be exposed to deadly heat for at least 20 days a year by the end of the century, or three quarters if emissions are allowed to grow. A modest warming of 1.5 degrees will raise the risks of deadly heatwaves in cities, lead to a higher incidence of diseases like malaria and dengue fever, reduce yields of vital crops like maize, rice and wheat, and negatively affect agricultural and coastal livelihoods, increasing poverty and disadvantage. Rising temperatures could depress the living standards of 800 million people in South Asia alone. And as early as 2030, extreme heat could lead to a $2 trillion loss in labour productivity globally.
A slow but steady shift
“History teaches us that when capitalism makes big profits through doing bad business, it ends up failing badly too, both politically and corporately. As responsible capitalists, we must always seek to do the right thing, in the right way, for the right reason or we, and society as a whole, will pay a very high ultimate price.” - Anne Richards, CEO, Fidelity international
Ten years may seem a long time, but will it be enough to dethrone shareholder value? There may be too many entrenched interests for a rapid shift towards more comprehensive reporting in the service of long-term, holistic value analysis; too many parties whose agendas are difficult to reconcile. But populations are rising in protest, and there is no turning back. Ultimately, reputations make and break companies; those that break their social contract will increasingly see their value destroyed - not just in intangible ways, but financially too.
 For a discussion of the findings on ESG investing, see our work on ‘ESG investing: is it worth it?’. In ‘We must review the purpose of the company’, leading FT columnist Martin Wolf reviews several new books (including one by Colin Mayer) on the corporate pursuit of profit, and what needs to change.
 Some economists argue that Smith’s principles in fact call for a less monopolistic and more equitable, localised, and sustainable economy that does protect the interest of the public as opposed to the rent-seeking of individual groups. One of these is David Korten, a critic of corporate globalisation, who makes this case in his best-known publication “When Corporations Rule the World”.
 For an in-depth analysis of the context to Adam Smith’s writing and the way it has at times been mis-appropriated, see Professor Gavin Kennedy’s “An authentic account of Adam Smith”. Professor Kennedy’s blog “Adam Smith’s lost legacy” relates this to individual instances, for example on the self interests of monopolists, protectionists and others not doing society any good, on the separation of ownership and management, and on not confusing self interest with selfishness.
 “Even at the height of the shareholder value movement, there was concern for CSR, ‘corporate social responsibility’, now more often described as ‘the ESG (environmental, social, governance) agenda’. But this approach falls far short of recognising the challenge which Drucker identified more than half a century ago – to understand the nature of the corporation as social organisation to define and legitimise its role in the communities in which it operates. Rather the CSR agenda attempts to answer the concerns of progressive individual who are not much interested in business – and certainly not interested in the mechanics of organising a large corporation and constructing productive corporate strategies. The result has been a proliferation of brochures printed on recycled paper and displaying pictures of smiling figures from ethnic minorities, accompanied by bland and substantially false clichés about making profits by doing good. This approach sidesteps the much more substantive issues of the proper role and function of the large business organisation in the global economy.” (Professor John Kay in “The concept of the corporation”.)
 Malcolm S. Salter, James J. Hill Professor of Business Administration Emeritus at Harvard Business School and Faculty Associate at the Edmund J. Safra Center for Ethics at Harvard University, “Rehabilitating Corporate Purpose”, 3 November 2018. (Draft paper not yet published). In the interest of full disclosure, Professor Salter is the father of Ned Salter, Head of Equity at Fidelity International.
 More on the adoption of the integrated reporting framework here and here. Integrated reporting is the subject of much academic research, some of which is collated here. Novo Nordisk’s approach is outlined here.
 At Fidelity International, we adopt a positive engagement approach whereby we discuss these issues with the management of the companies in which we invest or are considering investing on behalf of our clients. We use the information gathered during these meetings both to inform our investment decisions and to encourage company management to improve procedures and policies.
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